Property, Plant, and Equipment, and Intangibles Chapter 8 Operating Assets: Property, Plant, and Equipment, and Intangibles Using Financial Accounting Information: The Alternative to Debits and Credits, 6e by Gary A. Porter and Curtis L. Norton Copyright © 2009 South-Western, a part of Cengage Learning.

Nike, Inc. Property, Plant, and Equipment 2006 (in millions) Land $ 195.9 Buildings 842.6 Machinery and equipment 1,661.7 Leasehold improvements 626.7 Construction in progress 81.4 $ 3,408.3 Less accumulated depreciation (1,750.6) Property, plant, and equipment (net) $ 1,657.7 At Cost Book Value LO 1

Acquisition Cost of PP&E All costs necessary to acquire asset and prepare for intended use Examples: Purchase price Taxes paid at time of purchase Transportation charges Installation costs Purchase Price + Taxes LO 2

Group Asset Purchases Fair Market % of Cost Allocated Value Market Allocate cost of lump-sum purchase based on fair market values: Land = $30,000 Building = $90,000 Fair Market Value $75,000 $25,000 Allocated Cost 75% X 25% X % of Market Value Cost $100,000 = LO 3

Capitalization of Interest Interest can be included as part of the cost of an asset if: company constructs asset over time, and borrows money to finance construction

Depreciation of PP&E via Match costs of With periods assets benefited Straight-Line Accelerated Methods Units of Production LO 5

Straight-Line Method Allocates cost of asset evenly over its useful life $9,000 3-year life $3,000 Year 1 Year 2 Year 3

Units-of-Production Method Allocate asset cost based on number of units produced over its useful life Depreciation = $ per unit

Double-Declining-Balance Method Double the straight-line rate on a declining balance (book value) Accelerated method—higher amount of depreciation in early years Straight-line Rate x 2

Depreciation Example On January 1, 2008, ExerCo purchases a machine for $20,000. The life of the machine is estimated at five years, after which it is expected to be sold for $2,000.

$20,000 cost - $2,000 residual value = $18,000 to be depreciated Depreciation Example Calculate ExerCo’s depreciation of the machine for 2008-2012 using the units-of-production and double-declining- balance depreciation methods. $20,000 cost - $2,000 residual value = $18,000 to be depreciated

Straight-Line Depreciation Depreciation = Cost - Residual Value Life = $20,000 - $2,000 5 years = $3,600/year $18,000 5-year life $3,600 2008 $3,600 2009 $3,600 2010 $3,600 2011 $3,600 2012

Units-of-Production Depreciation ExerCo’s estimated machine production: 2008 3,600 units 2009 3,600 units 2010 3,600 units 2011 3,600 units 2012 3,600 units Total 18,000 units

Units-of-Production Depreciation Depreciation = Cost - Residual Value per unit Life in Units = $20,000 - $2,000 18,000 = $ 1.00 per unit

Units-of-Production Depreciation ExerCo’s depreciation in 2008: 4,000 units x $1/unit = $ 4,000

Double-Declining-Balance Depreciation DDB rate = (100% / useful life) x 2 = (100% / 5 years) x 2 = 40% Initially ignore residual value

Double-Declining-Balance Depreciation 2008 Depreciation = Beginning book value x rate = $20,000 x 40% = $8,000 Beginning Ending Year Rate Book Value Depreciation Book Value 2008 40% $20,000 $8,000 $12,000

Double-Declining-Balance Depreciation 2008 Depreciation = Beginning Book Value × Rate = $12,000 × 40% = $4,800 Beginning Ending Year Rate Book Value Depreciation Book Value 40% $20,000 $8,000 $12,000 40% $12,000 $4,800 $ 7,200

Double Declining-Balance Depreciation Beginning Ending Year Rate Book Value Depreciation Book Value 2008 40% $20,000 $8,000 $12,000 2009 40% 12,000 4,800 7,200 2010 40% 7,200 2,880 4,320 2011 40% 4,320 1,728 2,592 2012 40% 2,592 592 2,000 $18,000 Final year’s depreciation = amount needed to equate book value with salvage value = Residual Value

Straight-line vs. DDB Depreciation 2008 2009 2010 2011 2012

Reasons for Choosing Straight-Line Depreciation Simplicity Reporting to stockholders Comparability Bonus plans

Reasons for Choosing Accelerated Methods Technological rate of change and competitiveness Minimize taxable income Comparability

Changes in Depreciation Estimates Recompute depreciation schedule using new estimates Record prospectively (i.e., change should affect current and future years only) LO 6

Change in Estimate Example: planned $3,600 $3,600 $3,600 2008 2009 $20,000 machine originally expected to be depreciated over 5 years. After 2 years, useful life is increased to 7 years. planned $3,600 $3,600 $3,600 2008 2009 2010 2011 2012 Depreciation Revise estimate

Change in Estimate Example: 2008 2009 2010 2011 2012 2013 2014 Revise $12,800 remaining book value allocated prospect over remaining life $3,600 $2,160 $2,160 $2,160 2008 2009 2010 2011 2012 2013 2014 Revise estimate Depreciation

Capital vs. Revenue Expenditures Balance Sheet Capital Expenditure Treat as asset addition to be depreciated over a period of time Income Statement Revenue Expenditure Expense immediately LO 7

Capital vs. Revenue Expenditures Category Example Asset or Expense Normal maintenance Repainting Expense Minor repair Replace spark plugs Expense Major repair Replace a vehicle’s engine Asset* Addition Add a wing to a building Asset *if life or productivity is enhanced

Capital Expenditures Example: planned $3,600 $3,600 $3,600 2008 2009 A $20,000 machine purchased on January 1, 2008 is originally expected to be depreciated over 5 years. After 2 years, an overhaul of the machine is made at a cost of $3,000. Machine life is increased by 3 years. planned $3,600 $3,600 $3,600 2008 2009 2010 2011 2012 Major overhaul

Capital Expenditures Example: 2008 2009 2010 2011 2012 2013 2014 $12,800 remaining book value + $3,000 capital expenditure depreciated prospectively over remaining life $3,600 $2,300 $2,300 $2,300 2008 2009 2010 2011 2012 2013 2014 Major overhaul

Disposal of Operating Assets Record depreciation up to date of disposal Compute gain or loss on disposal Proceeds > Book Value = Gain Proceeds < Book Value = Loss LO 8

Disposal of Operating Assets Example: Sell truck (cost $20,000; accumulated depreciation $9,000) for $12,400 Sale price $ 12,400 Less book value: Asset cost $20,000 Less: accumulated depreciation 9,000 ( 11,000) Gain on sale $ 1,400

Long-term assets with no physical properties Intangible Assets Long-term assets with no physical properties Patents Copyrights Trademarks Goodwill LO 9

Acquisition Cost (i.e., legal fees, registration fees, etc.) Intangible Assets Includes cost to acquire and prepare for intended use Acquisition Cost (i.e., legal fees, registration fees, etc.) + Purchase Price +

Nike, Inc. Partial Balance Sheet (in millions) 2006 Amortized Intangible Assets: Patents $ 23.6 Trademarks 34.6 Other 5.8 $ 64.0 Unamortized intangible assets: Trademarks $341.5 Total $405.5 Goodwill $130.8 Intangible Assets

Research & Development Must be expensed in period incurred Difficult to identify future benefits

Amortization of Intangibles Normally recorded using straight-line method Reported net of accumulated amortization Amortized over legal or useful life, whichever is shorter LO 10

Amortization of Intangibles Only amortize intangible assets with definite life E.g.. Patents, copyrights

Amortization of Intangibles Example: Nike developed a patent for $10,000. The patent’s legal life is 20 years, but its anticipated useful life is 5 years.

Amortization of Intangibles with Finite Life To record amortization of patent for one year Balance Sheet Income Statement Assets = Liabilities + Stockholders’ + Revenues - Expenses Equity Patent (2,000) Patent Amortization Expense (2,000) Nike’s annual amortization: Patent approval costs $10,000 Divided by: Lesser of legal or useful life 5 years Annual amortization $ 2,000

Intangibles with Indefinite Life These intangibles are not amortized E.g., Broadcast license, trademarks, goodwill Should test annually for “impairment” If asset is impaired, record “Loss on Impairment”

Long-term Assets and the Statement of Cash Flows Operating Activities Net income xxx Depreciation and amortization + Gain on sale of asset - Loss on sale of asset + Investing Activities Purchase of asset - Sale of asset + Financing Activities LO 11

Analyzing Long-term Assets Average Life = Property, Plant, & Equipment Depreciation Expense What is the average depreciable period (or life) of the company’s assets? LO 12

Analyzing Long-term Assets Average Age = Accumulated Depreciation Depreciation Expense Are assets old or new?

Analyzing Long-term Assets Asset Turnover = Net Sales Average Total Assets How productive are the company’s assets?

End of Chapter 8